Although the PE ratio can be a very misleading indicator of future stock returns in the SHORT RUN, in the LONG RUN, the PE ratio is a very useful predictor. The reasons may be understood by analysing how stock and bond returns are calculated.
Current yield of a bond
= interest received / the price paid
This is a good measure of future return if the bond is not selling at a large premium or discount to its maturity value.
Earnings yield of a stock
= EPS / Price
= 1 / (PE)
Bonds vs Stocks
Stocks
- Since the underlying assets of a firm or stock are real, the earnings yield is a REAL, or inflation-adjusted, return.
- Over time, inflation will raise the cash flows from the underlying assets, and the assets themselves will appreciate in value.
- In contrast, the NOMINAL return earned from fixed-income assets, where all the coupons and the final payment are fixed in money terms and do not rise with inflation.
The long-run data bear out the contention that the earnings yield is a good long-run estimate of real stock returns.
- The average PE ratio of the market over the past 130 years has been 14.45, so the average earnings yield on stocks has been 1/14.45, or 6.8%.
- This earnings yield exactly matches the 6.8% real return on equities from 1871.
Predicting Future Short-term Stock Returns using PE ratio
There are limitations to using the PE ratio to predict future short-term stock returns.
For example, future returns will be higher than predicted by the earnings yield if the economy is emerging from a recession.
And in the short run, there are many other sources of market movement, such as:
- changes in interest rates or
- the risk premium demanded by stockholders.
No comments:
Post a Comment